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Unexpectedly Weak Employment Report; Beware the Sahm Rule?

Earlier this week, as we discussed in this blog post, the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) voted to leave its target for the federal funds rate unchanged. In his press conference following the meeting, Fed Chair Jerome Powell stated that: “Overall, a broad set of indicators suggests that conditions in the labor market have returned to about where they stood on the eve of the pandemic—strong but not overheated.”

This morning (August 2), the Bureau of Labor Statistics (BLS) released its “Employment Situation” report (often referred to as the “jobs report”) for July, which indicates that the labor market may be weaker than Powell and the other members of the FOMC believed it to be when they decided to leave their target for the federal funds rate unchanged.

The jobs report has two estimates of the change in employment during the month: one estimate from the establishment survey, often referred to as the payroll survey, and one from the household survey. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1), many economists and policymakers at the Federal Reserve believe that employment data from the establishment survey provides a more accurate indicator of the state of the labor market than do either the employment data or the unemployment data from the household survey. (The groups included in the employment estimates from the two surveys are somewhat different, as we discuss in this post.)

According to the establishment survey, there was a net increase of 114,000 jobs during July. This increase was below the increase of 175,000 to 185,000 that economists had forecast in surveys by the Wall Street Journal and bloomberg.com. The following figure, taken from the BLS report, shows the monthly net changes in employment for each month during the past two years.

The previously reported increases in employment for April and May were revised downward by 29,000 jobs. (The BLS notes that: “Monthly revisions result from additional reports received from businesses and government agencies since the last published estimates and from the recalculation of seasonal factors.”) As we’ve discussed in previous posts (most recently here), downward revisions to the payroll employment estimates are particularly likely at the beginning of a recession, although this month’s adjustments were relatively small.

As the following figure shows, the net change in jobs from the household survey moves much more erratically than does the net change in jobs in the establishment survey. The net change in jobs as measured by the household survey declined from 116,000 in June to 67,000 in June. So, in this case the direction of change in the two surveys was the same—a decline in the increase in the number of jobs.

As the following figure shows, the unemployment rate, which is also reported in the household survey, increased from 4.1 percent to 4.3 percent—the highest unemployment rate since October 2021. Although still low by historical standards, July was the fifth consecutive month in which the unemployment rate increased. It is also higher than the unemployment rate just before the pandemic. The unemployment rate was below 4 percent most months from mid-2018 to early 2020.

Some economists and policymakers have been following the Sahm rule, named after Claudia Sahm Chief Economist for New Century Advisors and a former Fed economist. The Sahm rule, as stated on the site of the Federal Reserve Bank of St. Louis is: “Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3 [measure]) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.” The following figure shows the values of this indicator dating back to March 1949.

So, according to this indicator, the U.S. economy is now at the start of a recession. Does that mean that a recession has actually started? Not necessarily. As Sahm stated in an interview this morning, her indicator is a historical relationship that may not always hold, particularly given how signficantly the labor market has been affected during the last four years by the pandemic.

As we noted in a post earlier this week, investors who buy and sell federal funds futures contracts assigned a probability of 11 percent that the FOMC would cut its target for the federal funds rate by 0.50 percentage point at its next meeting. (Investors in this market assigned a probability of 89 percent that the FOMC would cut its target by o.25 percentage point.) Today, investors dramatically increased the probability to 79.5 percent of a 0.50 cut in the federal funds rate target, as shown in this figure from the CME site.

Investors on the stock market appear to believe that the probability of a recession beginning before the end of the year has increased, as indicated by sharp declines today in the stock market indexes.

The next scheduled FOMC meeting isn’t until September 17-18. The FOMC is free to meet in between scheduled meetings but doing so might be interpreted as meanng that economy is in crisis, which is a message the committee is unlikely to want to send. It would likely take additional unfavorable reports on macro data for the FOMC not to wait until September to take action on cutting its target for the federal funds rate.

FOMC Holds Rate Target Steady While Hinting at a Cut at the September Meeting

Image of “Federal Reserve Chair Jerome Powell speaking at a podium” generated by GTP-4o.

At the conclusion of its July 30-31 meeting, the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) voted unamiously to leave its target range for the federal funds rate unchanged at 5.25 percent to 5.5 percent. (The statement the FOMC issued following the meeting can be found here.)

In the statement Fed Chair Jerome Powell read at the beginning of his press conference after the meeting, Powell appeared to be repeating a position he has stated in speeches and interviews during the past month:

“We have stated that we do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2 percent. The second-quarter’s inflation readings have added to our confidence, and more good data would further strengthen that confidence. We will continue to make our decisions meeting by meeting.”

But in answering questions from reporters, he made it clear that—as many economists and Wall Street investors had already concluded—the FOMC was likely to reduce its target for the federal funds rate at its next meeting on September 17-18. Powell noted that recent data were consistent with the inflation rate continuing to decline toward the Fed’s 2 percent annual target. Powell summarized the consensus from the discussion among committee members as being that “the time was approaching for cutting rates.”

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows the current values resulting from trading of federal funds futures.

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s September meeting. The chart indicates that investors assign a probability of 100 percent to the FOMC cutting its federal funds rate target at this meeting. Investors assign a probability of 89.0 percent that the committee will cut its target by 0.25 percentage point and a probability of 11.0 percent that the commitee will cut its target by 0.50 percentage point. When asked at his press conference whether the committee had given any consideration to making a 0.50 percentage point cut in its target, Powell said that it hadn’t.

Powell stated that the latest data on wage increases had led the committee to conclude that the labor market was no longer a source of inflationary pressure. The morning of the press conference, the Bureau of Labor Statistics (BLS) released its latest report on the Employment Cost Index (ECI). As we’ve noted in earlier posts, as a measure of the rate of increase in labor costs, the FOMC prefers the ECI to average hourly earnings (AHE).

As a measure of how wages are increasing or decreasing during a particular period, AHE can suffer from composition effects because AHE data aren’t adjusted for changes in the mix of occupations workers are employed in. In contrast, the ECI holds the mix of occupations constant. The ECI does have the drawback that it is only available quarterly whereas the AHE is available monthly.

The following figure shows the percentage change in the ECI for all civilian workers from the same quarter in the previous year. The blue line looks only at wages and salaries, while the red line is for total compensation, including non-wage benefits like employer contributions to health insurance. The rate of increase in the wage and salary measure decreased slightly from 4.3 percent in the first quarter of 2024 to 4.2 percent in the second quarter of 2024. The rate of increase in compensation also declined slightly from 4.2 percent to 4.1 percent. As the figure shows, both measures continued their declines from the peak of wage inflation during the second quarter of 2022. In his press conference, Powell said that the this latest ECI report was a little better than the committee had expected.

Finally, Powell noted that the committee saw no indication that the U.S. economy was heading for a recession. He observed that: “The labor market has come into better balance and the unemployment rate remains low.” In addition, he said that output continued to grow steadily. In particular, he pointed to growth in real final sales to private domestic purchasers. This macro variable equals the sum of personal consumption expenditures and gross private fixed investment. By excluding exports, government purchases, and changes in inventories, final sales to private domestic purchasers removes the more volatile components of gross domestic product and provides a better measure of the underlying trend in the growth of output.

As the following figure shows, this measure of output has grown at an annual rate of more than 2.5 percent in each of the last three quarters. Output expanding at that rate is indicative of an economy that is neither overheating nor heading toward a recession.

At this point, unless macro data releases are unexpectedly strong or weak during the next six weeks, it seems nearly certain that at its September meeting the FOMC will reduce its target range for the federal funds rate by 0.25 percentage point.

Latest PCE Report Shows Inflation Continues to Ease

Federal Reserve Chair Jerome Powell at a press conference following a meeting of the Federal Open Market Committee (Photo from federal reserve.gov)

Inflation in 2024 is a tale of two quarters. During the first quarter of 2024, inflation ran higher than expected considering the falling inflation rates at the end of 2023. As a result, although at the beginning of the year many economists and Wall Street analysts had expected the Federal Reserve’s policy-making Federal Open Market Committee (FOMC) would cut its target for the federal funds rate at least once in the first half of 2024, the FOMC left its target unchanged.

On July 26, the Bureau of Economic Analysis (BEA) released its “Personal Income and Outlays” report for June. The report includes monthly data on the personal consumption expenditures (PCE) price index. The Fed relies on annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target. The report confirmed that PCE inflation slowed in the second quarter, bringing it closer to the Fed’s 2 percent target.

The following figure shows PCE inflation (blue line) and core PCE inflation (red line)—which excludes energy and food prices—for the period since January 2015 with inflation measured as the percentage change in the PCE from the same month in the previous year. Measured this way, in June PCE inflation (the blue line) was 2.5 percent, down slightly from PCE inflation of 2.6 percent in May. Core PCE inflation (the red line) in June was also 2.5 percent, which was unchanged from May.

The following figure shows PCE inflation and core PCE inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month inflation, while this figure shows 1-month inflation.) Measured this way, PCE inflation rose in June to 0.9 percent from 0.4 percent in May—although higher in June, inflation was well below the Fed’s 2 percent target in both months. Core PCE inflation rose from 1.5 percent in May to 2.0 percent in June. These data indicate that inflation has been at or below the Fed’s target for the last two months.

The following figure shows another way of gauging inflation by including the 12-month inflation rate in the PCE (the same as shown in the figure above—although note that PCE inflation is now the red line rather than the blue line), inflation as measured using only the prices of the services included in the PCE (the green line), and the trimmed mean rate of PCE inflation (the blue line). Fed Chair Jerome Powell and other members of the Federal Open Market Committee (FOMC) have said that they are concerned by the persistence of elevated rates of inflation in services. The trimmed mean measure is compiled by economists at the Federal Reserve Bank of Dallas by dropping from the PCE the goods and services that have the highest and lowest rates of inflation. It can be thought of as another way of looking at core inflation by excluding the prices of goods and services that had particularly high or particularly low rates of inflation during the month.

Inflation using the trimmed mean measure was 2.8 percent in June (calculated as a 12-month inflation rate), down only slightly from 2.9 percent in May—and still above the Fed’s target inflation rate of 2 percent. Inflation in services remained high in June at 3.9 percent, down only slightly from 4.0 percent in May.

This month’s PCE inflation data indicate that the inflation rate is still declining towards the Fed’s target, with the low 1-month inflation rates being particularly encouraging. It now seems likely that the FOMC will soon lower the committee’s target for the federal funds rate, which is currently 5.25 percent to 5.50 percent. Remarks by Fed Chair Powell have been interpreted as hinting as much. The next meeting of the FOMC is July 30-31. What do financial markets think the FOMC will decide at that meeting?

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s July meeting. The chart indicates that investors assign a probability of only 4.7 percent to the FOMC cutting its federal funds rate target by 0.25 percentage point at its July 30-31 meeting and an 95.3 percent probability of the commitee leaving the target unchanged.

In contrast, the following figure shows that investors expect that the FOMC will cut its federal funds rate at the meeting scheduled for September 17-18. Investors assign an 87.7 percent probability of a 0.25 percentage point cut and a 11.9 percent probability of a 0.50 percentage point cut. The committee deciding to leave the target unchanged at 5.25 percent to 5.50 percent is effectively assigned a zero probability. In other words, investors believe with near certainty that the FOMC will reduce its target for the federal funds rate for the first time since the current round of rate increases ended in July 2023.

Latest PCE Report Shows Inflation Slowing

Chair Jerome Powell and other members of the Federal Open Market Committee (Photo from federalreserve.gov)

On Friday, June 28, the Bureau of Economic Analysis (BEA) released its “Personal Income and Outlays” report for April, which includes monthly data on the personal consumption expenditures (PCE) price index. Inflation as measured by annual changes in the consumer price index (CPI) receives the most attention in the media, but the Federal Reserve looks instead to inflation as measured by annual changes in the PCE price index to evaluate whether it’s meeting its 2 percent annual inflation target.

The following figure shows PCE inflation (blue line) and core PCE inflation (red line)—which excludes energy and food prices—for the period since January 2015 with inflation measured as the change in the PCE from the same month in the previous year. Measured this way, in May PCE inflation (the blue line) was 2.6 percent in May, down slightly from PCE inflation of 2.7 percent in April. Core PCE inflation (the red line) in May was also 2.6 percent, down from 2.8 percent in April.

The following figure shows PCE inflation and core PCE inflation calculated by compounding the current month’s rate over an entire year. (The figure above shows what is sometimes called 12-month inflation, while this figure shows 1-month inflation.) Measured this way, PCE inflation sharply declined from 3.2 percent in April to -0.1 percent in in May—meaning that consumer prices actually fell during May. Core PCE inflation declined from 3.2 percent in April to 1.0 percent in May. This decline indicates that inflation by either meansure slowed substantially in May, but data for a single month should be interpreted with caution.

Inflation using the trimmed mean measure was 2.8 percent in May (calculated as a 12-month inflation rate), down only slightly from 2.9 percent in April—and still well above the Fed’s target inflation rate of 2 percent. Inflation in services remained high in May at 3.9 percent, down only slightly from 4.0 percent in April.

This month’s PCE inflation data indicate that the inflation rate is still declining towards the Fed’s target, with the low 1-month inflation rates being particularly encouraging. But the FOMC will likely need additional data before deciding to lower the committee’s target for the federal funds rate, which is currently 5.25 percent to 5.50 percent. The next meeting of the FOMC is July 30-31. What do financial markets think the FOMC will decide at that meeting?

The probabilities in the chart reflect investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s July meeting. The chart indicates that investors assign a probability of only 10.3 percent to the FOMC cutting its federal funds rate target by 0.25 percentage point at that meeting and an 89.7 percent probability of the commitee leaving the target unchanged.

In contrast, the following figure shows that investors expect that the FOMC will cut its federal funds rate at the meeting scheduled for September 17-18. Investors assign a 57.9 percent probability of a 0.25 percentage point cut and a 6.2 percent probability of a 0.50 percentage point cut. The committee deciding to leave the target unchanged at 5.25 percent to 5.50 percent is assigned a probability of only 35.9 percent.

The FOMC Follows the Expected Course in Its Latest Meeting

Chair Jerome Powell at a meeting of the Federal Open Market Committee (photo from federalreserve.gov)

At the beginning of the year, there was an expectation among some economists and policymakers that the Fed’s policy-making Federal Open Market Committee (FOMC) would begin cutting its target range for the federal funds rate at the meeting that ended today (May 1). The Fed appeared to be bringing the U.S. economy in for a soft landing—inflation returning to the Fed’s 2 percent target without a recession occurring.

During the first quarter of 2024, production and employment have been expanding more rapidly than had been expected and inflation has been higher than expected. As a result, the nearly universal expectation prior to this meeting was that the FOMC would leave its target for the federal funds rate unchanged. Some economists and investment analysts have begun discussing the possiblity that the committee might not cut its target at all during 2024. The view that interest rates will be higher for longer than had been expected at the beginning of the year has contributed to increases in long-term interest rates, including the interest rates on the 10-year Treasury Note and on residential mortgage loans.

The statement that the FOMC issued after the meeting confirmed the consensus view:

“Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated. In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.”

In his press conference after the meeting, Fed Chair Jerome Powell emphasized that the FOMC was unlikely to cut its target for the federal funds rate until data indicated that the inflation rate had resumed falling towards the Fed’s 2 percent target. At one point in the press conference Powell noted that although it was taking longer than expected for the inflation rate to decline he still expected that the pace of economic actitivity was likely to slow sufficiently to allow the decline to take place. He indicated that—contrary to what some economists and investment analysts had suggested—it was unlikely that the FOMC would raise its target for the federal funds rate at a future meeting. He noted that the possibility of raising the target was not discussed at this meeting.

Was there any news in the FOMC statement or in Powell’s remarks at the press conference? One way to judge whether the outcome of an FOMC meeting is consistent with the expectations of investors in financial markets prior to the meeting is to look at movements in stock prices during the time between the release of the FOMC statement at 2 pm and the conclusion of Powell’s press conference at about 3:15 pm. The following figure from the Wall Street Journal, shows movements in the three most widely followed stock indexes—the Dow Jones Industrial Average, the S&P 500, and the Nasdaq composite. (We discuss movements in stock market indexes in Macroeconomics and Essentials of Economics, Chapter 6, Section 6.2 and in Economics, Chapter 8, Section 8.2.)

If either the FOMC statement or the Powell’s remarks during his press conference had raised the possibility that the committee was considering raising its target for the federal funds rate, stock prices would likely have declined. The decline would reflect investors’ concern that higher interest rates would slow the economy, reducing future corporate profits. If, on the other hand, the statement and Powell’s remarks indicated that the committee would likely cut its target for the federal funds rate relatively soon, stock prices would likely have risen. The figure shows that stock prices began to rise after the 2 pm release of the FOMC statement. Prices rose further as Powell seemed to rule out an increase in the target at a future meeting and expressed confidence that inflation would resume declining toward the 2 percent target. But, as often happens in the market, this sentiment reversed towards the end of Powell’s press conference and two of the three stock indexes ended up lower at the close of trading at 4 pm. Presumably, investors decided that on reflection there was no news in the statement or press conference that would change the consensus on when the FOMC might begin lowering its target for the federal funds rate.

The next signficant release of macroeconomic data will come on Friday when the Bureau of Labor Statistics issues its employment report for April.

Will the Fed Not Cut Rates at All this Year?

Federal Reserve Vice Chair Philip Jefferson (photo from the Federal Reserve)

Federal Reserve Chair Jerome Powell (photo from the Federal Reserve)

At the beginning of 2024, investors were expecting that during the year the Fed’s policy-making Federal Open Market Committee (FOMC) would cut its target range for the federal funds rate six or seven times. At its meeting on March 19-20 the economic projections of the members of the FOMC indicated that they were expecting to cut the target range three times from its current 5.25 percent to 5.50 percent. But, as we noted in this recent post and in this podcast, macroeconomic data during the first three months of this year indicated that the U.S. economy was growing more rapidly than the Fed had expected and the reductions in inflation that occurred during the second half of 2023 had not persisted into the beginning of 2024.

The unexpected strength of the economy and the persistence of inflation above the Fed’s 2 percent target have raised the issue of whether the FOMC will cut its target range for the federal funds rate at all this year. Earlier this month, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis raised the possibility that the FOMC would not cut its target range this year.

Today (April 16) both Fed Vice Chair Philip Jefferson and Fed Chair Jerome Powell addressed the issue of monetary policy. They gave what appeared to be somewhat different signals about the likely path of the federal funds target during the remainder of this year—bearing in mind that Fed officials never commit to any specific policy when making a speech. Adressing the International Research Forum on Monetary Policy, Vice Chair Jefferson stated that:

“My baseline outlook continues to be that inflation will decline further, with the policy rate held steady at its current level, and that the labor market will remain strong, with labor demand and supply continuing to rebalance. Of course, the outlook is still quite uncertain, and if incoming data suggest that inflation is more persistent than I currently expect it to be, it will be appropriate to hold in place the current restrictive stance of policy for longer.”

One interpretation of his point here is that he is still expecting that the FOMC will cut its target for the federal funds rate sometime this year unless inflation remains persistently higher than the Fed’s target—which he doesn’t expect.

Chair Powell, speaking at a panel discussion at the Wilson Center in Washington, D.C., seemed to indicate that he believed it was less likely that the FOMC would reduce its federal funds rate target in the near future. The Wall Street Journal summarized his remarks this way:

“Federal Reserve Chair Jerome Powell said firm inflation during the first quarter had introduced new uncertainty over whether the central bank would be able to lower interest rates this year without signs of an economic slowdown. His remarks indicated a clear shift in the Fed’s outlook following a third consecutive month of stronger-than-anticipated inflation readings ….”

An article on bloomberg.com had a similar interpretation of Powell’s remarks: “Federal Reserve Chair Jerome Powell signaled policymakers will wait longer than previously anticipated to cut interest rates following a series of surprisingly high inflation readings.”

Politics may also play a role in the FOMC’s decisions. As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), the Federal Reserve Act, which Congress passed in 1913 and has amended several times since, puts the Federal Reserve in an unusal position in the federal government. Although the members of the Board of Governors are appointed by the president and confirmed by the Senate, the Fed was intended to act independently of Congress and the president. Over the years, Fed Chairs have protected that independence by, for the most part, avoiding taking actions beyond the narrow responsibilites Congress has given to the Fed by Congress and by avoiding actions that could be interpreted as political.

This year is, of course, a presidential election year. The following table from the Fed’s web site lists the FOMC meetings this year. The presidential election will occur on November 5. There are four scheduled FOMC meetings before then. Given that inflation has been running well above the Fed’s target during the first three months of the year, it would likely take at least two months of lower inflation data—or a weakening of the economy as indicated by a rising unemployment rate—before the FOMC would consider lowering its federal funds rate target. If so, the meeting on July 30-31 might be the first meeting at which a rate reduction would occur. If the FOMC doesn’t act at its July meeting, it might be reluctant to cut its target at the September 17-18 meeting because acting close to the election might be interpreted as an attempt to aid President Joe Biden’s reelection.

Although we don’t know whether avoiding the appearance of intervening in politics is an important consideration for the members of the FOMC, some discussion in the business press raises the possibility. For instance, a recent article in the Wall Street Journal noted that:

“The longer that officials wait, the less likely there will be cuts this year, some analysts said. That is because officials will likely resist starting to lower rates in the midst of this year’s presidential election campaign to avoid political entanglements.”

These are clearly not the easiest times to be a Fed policymaker!

Upward Revision of 2023 Fourth Quarter Real GDP Growth May Add to Fed’s Hesitancy to Raise Fed Funds Target

(Photo courtesy of Lena Buonanno)

The Bureau of Economic Analysis (BEA) has issued its third estimate of real GDP for the fourth quarter of 2023. The BEA now estimates that real GDP increased in the fourth quarter of 2023 at an annual rate of 3.4 percent, an increase from the BEA’s second estimate of 3.2 percent. The BEA noted that: “The update primarily reflected upward revisions to consumer spending and nonresidential fixed investment that were partly offset by a downward revision to private inventory investment.”

As the blue line in the following figure shows, despite the upward revision, fourth quarter growth in real GDP decline significantly from the very high growth rate of 4.9 percent in the third quarter. In addition, two widely followed “nowcast” estimates of real GDP growth in the first quarter of 2024 show a futher slowdown. The nowcast from the Federal Reserve Bank of Atlanta estimates that real GDP will have grown at an annualized rate of 2.1 percent in the first quarter and the nowcast from the Federal Reserve Bank of New York estimates a growth rate of 1.9 percent. (The Atlanta Fed describes its nowcast as “a running estimate of real GDP growth based on available economic data for the current measured quarter.” The New York Fed explains: “Our model reads the flow of information from a wide range of macroeconomic data as they become available, evaluating their implications for current economic conditions; the result is a ‘nowcast’ of GDP growth ….”)

Data on growth in real gross domestic income (GDI), on the other hand, show an upward trend, as indicated by the red line in the figure. As we discuss in Macroeconomics, Chapter 8, Section 8.4 (Economics, Chapter 18, Section 18.4), gross domestic product measures the economy’s output from the production side, while gross domestic income does so from the income side. The two measures are designed to be equal, but they can differ because each measure uses different data series and the errors in data on production can differ from the errors in data on income. Economists differ on whether data on growth in real GDP or data on growth in real GDI do a better job of forecasting future changes in the economy. Accordingly, economists and policymakers will differ on how much weight to put on the fact that while the growth in real GDI had been well below growth in real GDP from the fourth quarter of 2022 to the fourth quarter of 2023, during the fourth quarter of 2023, growth in real GDI was 1.5 percentage points higher than growth in real GDP.

On balance, it seems likely that these data will reinforce the views of those members of the Fed’s policy-making Federal Open Market Committee (FOMC) who were cautious about reducing the target for the federal funds rate until the macroeconomic data indicate more clearly that the economy is slowing sufficiently to ensure that inflation is returning to the Fed’s 2 percent target. In a speech on March 27 (before the latest GDP revisions became available), Fed Governor Christopher Waller reviewed the most recent macro data and concluded that:

“Adding this new data to what we saw earlier in the year reinforces my view that there is no rush to cut the [federal funds] rate. Indeed, it tells me that it is prudent to hold this rate at its current restrictive stance perhaps for longer than previously thought to help keep inflation on a sustainable trajectory toward 2 percent.”

Most other members of the FOMC appear to share Waller’s view.

Key Macro Data Series during the Time Since the Arrival of Covid–19 in the United States

A bookstore in New York City closed during Covid. (Photo from the New York Times)

Four years ago, in mid-March 2020, Covid–19 began to significantly affect the U.S. economy, with hospitalizations rising and many state and local governments closing schools and some businesses. In this blog post we review what’s happened to key macro variables during the past four years. Each monthly series starts in February 2020 and the quarterly series start in the fourth quarter of 2019.

Production

Real GDP declined by 5.8 percent from the fourth quarter of 2019 to the first quarter of 2020 and by an additional 28.0 percent from the first quarter of 2020 to the second quarter. This decline was by far the largest in such a short period in the history of the United States. From the second quarter to the third quarter of 2020, as businesses began to reopen, real GDP increased by 34.8 percent, which was by far the largest increase in a single quarter in U.S. history.

Industrial production followed a similar—although less dramatic—path to real GDP, declining by 16.8 percent from February 2020 to April 2020 before increasing by 12.3 percent from April 2020 to June 2020. Industrial production did not regain its February 2020 level until March 2022. The swings in industrial production were smaller than the swings in GDP because industrial production doesn’t include the output of the service sector, which includes firms like restaurants, movie theaters, and gyms that were largely shutdown in some areas. (Industrial production measures the real output of the U.S. manufacturing, mining, and electric and gas utilities industries. The data are issued by the Federal Reserve and discussed here.)

Employment

Nonfarm payroll employment, collected by the Bureau of Labor Statistics (BLS) in its establishment survey, followed a path very similar to the path of production. Between February and April 2020, employment declined by an astouding 22 million workers, or by 14.4 percent. This decline was by far the largest in U.S. history over such a short period. Employment increased rapidly beginning in April but didn’t regain its February 2020 level until June 2022.

The employment-population ratio measures the percentage of the working-age population that is employed. It provides a more comprehensive measure of an economy’s utilization of available labor than does the total number of people employed. In the following figure, the blue line shows the employment-population ratio for the whole working-age population and the red line shows the employment-population ratio for “prime age workers,” those aged 25 to 54.

For both groups, the employment-population ratio plunged as a result of Covid and then slowly recovered as the production began increasing after April 2020. The employment-population ratio for prime age workers didn’t regain its February 2020 value until February 2023, an indication of how long it took the labor market to fully overcome the effects of the pandemic. As of February 2024, the employment-population ratio for all people of working age hasn’t returned to its February 2020 value, largely because of the aging of the U.S. population.

Average weekly hours worked followed an unusual pattern, declining during March 2020 but then increasing to beyond its February 2020 level to a peak in April 2021. This increase reflects firms attempting to deal with a shortage of workers by increasing the hours of those people they were able to hire. By April 2023, average weekly hours worked had returned to its February 2020 level.

Income

Real average hourly earnings surged by more than six percent between February and April 2020—a very large increase over a two-month period. But some of the increase represented a composition effect—as workers with lower incomes in services industries such as restaurants were more likely to be out of work during this period—rather than an actual increase in the real wages received by people employed during both months. (Real average hourly earnings are calculated by dividing nominal average hourly earnings by the consumer price index (CPI) and multiplying by 100.)

Median weekly real earnings, because it is calculated as a median rather than as an average (or mean), is less subject to composition effects than is real average hourly earnings. Median weekly real earnings increased sharply between February and April of 2020 before declining through June 2022. Earnings then gradually increased. In February 2024 they were 2.5 percent higher than in February 2020.

Inflation

The inflation rate most commonly mentioned in media reports is the percentage change in the CPI from the same month in the previous year. The following figure shows that inflation declined from February to May 2020. Inflation then began to rise slowly before rising rapidly beginning in the spring of 2021, reaching a peak in June 2022 at 9.0 percent. That inflation rate was the highest since November 1981. Inflation then declined steadily through June 2023. Since that time it has fluctuated while remaining above 3 percent.

As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), the Federal Reserve gauges its success in meeting its goal of an inflation rate of 2 percent using the personal consumption expenditures (PCE) price index. The following figure shows that PCE inflation followed roughly the same path as CPI inflation, although it reached a lower peak and had declined below 3 percent by November 2023. (A more detailed discussion of recent inflation data can be found in this post and in this post.)

Monetary Policy

The following figure shows the effective federal funds rate, which is the rate—nearly always within the upper and lower bounds of the Fed’s target range—that prevails during a particular period in the federal funds market. In March 2020, the Fed cut its target range to 0 to 0.25 percent in response to the economic disruptions caused by the pandemic. It kept the target unchanged until March 2022 despite the sharp increase in inflation that had begun a year earlier. The members of the Federal Reserve’s Federal Open Market Committee (FOMC) had initially hoped that the surge in inflation was largely caused by disuptions to supply chains and would be transitory, falling as supply chains returned to normal. Beginning in March 2022, the FOMC rapidly increased its target range in response to continuing high rates of inflation. The targer range reached 5.25 to 5.50 percent in July 2023 where it has remained through March 2024.

Although the money supply is no longer the focus of monetary policy, some economists have noted that the rate of growth in the M2 measure of the money supply increased very rapidly just before the inflation rate began to accelerate in the spring of 2021 and then declined—eventually becoming negative—during the period in which the inflation rate declined.

As we discuss in the new 9th edition of Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), some economists believe that the FOMC should engage in nominal GDP targeting. They argue that this approach has the best chance of stabilizing the growth rate of real GDP while keeping the inflation rate close to the Fed’s 2 percent target. The following figure shows the economy experienced very high rates of inflation during the period when nominal GDP was increasing at an annual rate of greater than 10 percent and that inflation declined as the rate of nominal GDP growth declined toward 5 percent, which is closer to the growth rates seen during the 2000s. (This figure begins in the first quarter of 2000 to put the high growth rates in nominal GDP of 2021 and 2022 in context.)

Fiscal Policy

As we discuss in the new 9th edition of Macroeconomics, Chapter 15 (Economics, Chapter 25), in response to the Covid pandemic Congress and Presidents Trump and Biden implemented the largest discretionary fiscal policy actions in U.S. history. The resulting increases in spending are reflected in the two spikes in federal government expenditures shown in the following figure.

The initial fiscal policy actions resulted in an extraordinary increase in federal expenditures of $3.69 trillion, or 81.3 percent, from the first quarter to the second quarter of 2020. This was followed by an increase in federal expenditures of $2.31 trillion, or 39.4 percent, from the fourth quarter of 2020 to the first quarter of 2021. As we recount in the text, there was a lively debate among economists about whether these increases in spending were necessary to offest the negative economic effects of the pandemic or whether they were greater than what was needed and contributed substantially to the sharp increase in inflation that began in the spring of 2021.

Saving

As a result of the fiscal policy actions of 2020 and 2021, many households received checks from the federal government. In total, the federal government distributed about $80o billion directly to households. As the figure shows, one result was to markedly increase the personal saving rate—measured as personal saving as a percentage of disposable personal income—from 6.4 percent in December 2019 to 22.0 in April 2020. (The figure begins in January 2020 to put the size of the spike in the saving rate in perspective.)

The rise in the saving rate helped households maintain high levels of consumption spending, particularly on consumer durables such as automobiles. The first of the following figure shows real personal consumption expenditures and the second figure shows real personal consumption expenditures on durable goods.

Taken together, these data provide an overview of the momentous macroeconomic events of the past four years.

Consumer Price Inflation Comes in Somewhat Higher than Expected

Federal Reserve Chair Jerome Powell (Photo from Bloomberg News via the Wall Street Journal.)

Economists, policymakers, and Wall Street analysts have been waiting for macroeconomic data to confirm that the Federal Reserve has brought the U.S. economy in for a soft landing, with inflation arrving back at the Fed’s target of 2 percent without the economy slipping into a recession. Fed officials have been cautious about declaring that they have yet seen sufficient data to be sure that a soft landing has actually been achieved. Accordingly, they are not yet willing to begin cutting their target for the federal funds rate.

For instance, on March 6, in testifying before the Commitee on Financial Services of the U.S. House of Representatives, Fed Chair Jerome Powell stated that the Fed’s Federal Open Market Committee (FOMC) “does not expect that it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” (Powell’s statement before his testimony can be found here.)

The BLS’s release today (March 12) of its report on the consumer price index (CPI) (found here) for February indicated that inflation was still running higher than the Fed’s target, reinforcing the cautious approach that Powell and other members of the FOMC have been taking. The increase in the CPI that includes the prices of all goods and services in the market basket—often called headline inflation—was 3.2 percent from the same month in 2023, up slightly from 3.1 In January. (We discuss how the BLS constructs the CPI in Macroeconomics, Chapter 9, Section 19.4, Economics, Chapter 19, Section 19.4, and Essentials of Economics, Chapter 3, Section 13.4.) As the following figure shows, core inflation—which excludes the prices of food and energy—was 3.8 percent, down slightly from 3.9 percent in January.

If we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—the values are more concerning, as indicated in the following figure. Headline CPI inflation is 5.4 percent (up from 3.7 percent in January) and core CPI inflation is 4.4 percent (although that is down from 4.8 percent in January). The Fed’s inflation target is measured using the personal consumption expenditures (PCE) price index, not the CPI. But CPI inflation at these levels is not consistent with PCE inflation of only 2 percent.

Even more concerning is the path of inflation in the prices of services. As we’ve noted in earlier posts, Chair Powell has emphasized that as supply chain problems have gradually been resolved, inflation in the prices of goods has been rapidly declining. But inflaion in services hasn’t declined nearly as much. Last summer he stated the point this way:

“Part of the reason for the modest decline of nonhousing services inflation so far is that many of these services were less affected by global supply chain bottlenecks and are generally thought to be less interest sensitive than other sectors such as housing or durable goods. Production of these services is also relatively labor intensive, and the labor market remains tight. Given the size of this sector, some further progress here will be essential to restoring price stability.”

The following figure shows the 1-month inflation rate in services prices and in services prices not included including housing rent. Some economists believe that the rent component of the CPI isn’t well measured and can be volatile, so it’s worthwhile to look at inflation in service prices not including rent. The figure shows that inflation in all service prices has been above 4 percent in every month since July 2023. Although inflation in service prices declined from January, it was still a very high 5.8 percent in February. Inflation in service prices not including housing rent was even higher at 7.5 percent. Such large increases in the prices of services, if they were to continue, wouldn’t be consistent with the Fed meeting its 2 percent inflation target.

Finally, some economists and policymakers look at median inflation to gain insight into the underlying trend in the inflation rate. If we listed the inflation rate in each individual good or service in the CPI, median inflation is the inflation rate of the good or service that is in the middle of the list—that is, the inflation rate in the price of the good or service that has an equal number of higher and lower inflation rates. As the following figure shows, although median inflation declined in February, it was still high at 4.6 percent and, although median inflation is volatile, the trend has been generally upward since July 2023.

The data in this month’s BLS report on the CPI reinforces the view that the FOMC will not move to cut its target for the federal funds rate in the meeting next week and makes it somewhat less likely that the committee will cut its target at the following meeting on April 30-May 1.

Economists vs. the Market in Predicting the First Cut in the Federal Funds Rate

The meeting room of the FOMC in the Federal Reserve building in Washington, DC.

As we’ve noted in several recent posts, the inflation rate has fallen significantly from its peak in mid-2022, as U.S. economic growth has been slowing and the labor market appears to be less tight, slowing the growth of wages. Some economists and policymakers now believe that by early 2024, inflation will approach the Fed Reserve’s 2 percent inflation target. At that point, the Fed’s Federal Open Market Committee (FOMC) is likely to turn its attention from inflation to making sure that the U.S. economy doesn’t slip into a recession.

Accordingly, both economists and financial market participants have begun to anticipate the point at which the FOMC will begin to cut its target for the federal funds rate. (One note of caution: Fed Chair Jerome Powell has made clear that the FOMC stands ready to further increase its target for the federal funds rate if the inflation rate shows signs of increasing. He made this point most recently on December 1 in a speech at Spelman College in Atlanta.) There is currently an interesting disagreement between economists and investors over when the FOMC is likely to cut interest rates and by how much. We can see the views of investors reflected in the futures market for federal funds.

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows values after trading of federal funds futures on December 5, 2023.

The probabilities in the chart reflects investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s meeting on March 20, 2024. This meeting is the first after which investors currently expect that the target is likely to be lowered. The target range is currently 5.25 percent to 5.50 percent. The chart indicates that investors assign a probability of 60.2 percent to the FOMC making at least a 0.25 percentage cut in the target rate at the March meeting.

Looking at the values for federal funds futures after the FOMC’s December 18, 2024 meeting, investors assign a 66.3 percent probability of the committee having reduced its target for the federal funds rate to 4.00 to 4.25 percent of lower. In other words, investors expect that during 2024, the FOMC will have cut its target for the federal funds rate by at least 1.25 percentage points.

Interesingly, according to a survey by the Financial Times, economists disagree with investors’ forecasts of the federal funds rate. According to the survey, which was conducted between December 1 and December 4, nearly two-thirds of economists believe that the FOMC won’t cut its target for the federal funds rate until July 2024 or later. Three-quarters of the economists surveyed believe that the FOMC will cut its target by 0.5 percent point or less during 2024. Fewer than 10 percent of the economists surveyed believe that during 2024 the FOMC will cut its target for the federal funds rate by 1.25 percent or more. (The Financial Times article describing the results of the survey can be found here. A subscription may be requred to read the article.)

So, at least among the economists surveyed by the Financial Times, the consensus is that the FOMC will cut its target for the federal funds rate later and by less than financial markets are indicating. What explains the discrepancy? The main explanation is that economists see inflation being persistently above the Fed’s 2 percent target for longer than do financial market participants. The economists surveyed are also more optimistic that the U.S. economy will avoid a recession in 2024. If a recession occurs, the FOMC is more likely to significantly cut its target than if the economy during 2024 experiences moderate growth in real GDP and the unemployment rate remains low.

One other indication from financial markets that investors expect that the U.S. economy is likely to slow during 2024 is given by movements in the interest rate on the 10-year U.S. Treasury note. As shown in the following figure, from August to October of this year, the interest rate on the 10-year Treasury note rose from less than 4 percent to nearly 5 percent—an unusually large change in such a short period of time. Since then, most of that increase has been reversed with the interest rate on the 10-year Treasury note having fallen below 4.2 percent in early December

The movements in the interest rate on the 10-year Treasury note typically reflect investors’ expectations of future short-term interest rates. (We discuss the relationship between short-term and long-term interests rates—which economists call the term structure of interest rates—in Money, Banking, and the Financial System, Chapter 5, Section 5.2.) The increase in the 10-year interest rate between August and October reflected investors’ expectation that short-term interest rates were likely to remain persistently high for a considerable period—perhaps several years or more. The decline in the 10-year rate from late October to early December reflects investors changing their expectations toward future short-term interest rates being lower than they had previously thought. Again, as in the data on federal funds rate futures, investors seem to be expecting either slower economic growth or slower inflation than do economists.

One other complication about the interest rate on the 10-year Treasury note should be mentioned. Some of the increase in the rate from August to October may also have represented concern among investors that large federal budget deficit would cause the Treasury to issue more Treasury notes than investors would be willing to buy without the Treasury increasing the interest rate investors would receive on the newly issued notes. This concern may have been reinforced by data showing that foreign investors, particularly in China and Japan, appeared to have slowed or stopped adding to their holdings of Treasury notes. Part of the recent decline in the interest rate on the Treasury note may reflect investors becoming less concerned about these two factors.